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Wednesday, May 16, 2012

The Cost of Stock Market Volatility

Few investors understand how volatility in investment returns costs them real money. I did some simulations to try to explain where the lost money goes.

In the hypothetical land of Volatilia, half of stocks return -70% each year and the other half return +80%. The problem for investors is that which stocks get each return changes randomly from year to year. There are a million active investors who each pick one stock every year and pile all of their savings into it. There are another million investors who use an index fund that owns all stocks in equal dollar amounts.

Assuming that all investors add $5000 per year to their savings, each index investor will end up with $634,200 after 40 years. Mathematically inclined readers will realize that the active investors will end up with the same average result, but there will be winners and losers.

On the surface, it seems like there is no real cost to trying the active route. You could end up with more money or less money, but the expected result is the same. However, the results of the simulation paint a very different picture.

Of the million active investors, over 95% end up with less than the index investors’ result of $634,200. In fact, about half of them end up with less than $24,800! So, if the active investors end up with the same average savings as the index investors, where did all the money go? A partial answer is that there were 54 active investor billionaires. About 1 out of 30 active investors became decamillionaires, and this group ended up with 75% of all the active investor money. So, the bulk of the active investor money was shifted to a few very wealthy investors.

When it comes to investing for the long term, the median result is much more important than the average result. An active investor should focus on the median figure of $24,800 rather than the average of $643,200. It is the index investor who eliminates volatility who can count on the larger amount.

Of course, in the real world the results are not this extreme, but the same idea applies. Reducing volatility isn’t just about sleeping better at night; you’re likely to end up with more savings as well.